Download GDP, Savings, and Loanable Funds

GDP, Savings, and Loanable Funds1
Instructional Primer2
GDP, Savings and the Loanable Funds Market are instruments through which we can connect certain
aspects of fiscal policy and monetary policy, both of which are important in macroeconomics. In many
Macro texts (including Krugman), we begin with a basic study of microeconomics and t hen transition to
macro. We do this because the mainstream view is that good macroeconomics should have micro
foundations, and one of the easier ways of illustrating this is through a discussion of the components of
markets (individuals, households, and firms) and economies (the economic make up of nation states) –
which can be observed through GDP, Savings and the Loanable Funds Market.
GDP is a nation’s output, or its income. We know that it can be calculated in three ways:
1. By measuring the value added in each step of the production process – which really is just a
process of accounting for the inputs to production and the profits generated; remember that
total costs plus profit equals total revenue and when we’re looking at GDP we’re looking at total
revenue.
2. By measuring all of the factor input payments – which is barely different than the description
above. In this we account for all of the factor input payments (which include costs and profits)
and include investors’ capital as an input, the payment for which is their profits.
3. By measuring consumption, investment, government spending and net exports – again each of
these embodies costs and profits.
In this introduction we’re going to focus on GDP as a function of C + I + G + Net Exports.
GDP = C + I + G + X - IM
(1)
G = T + B + θ (T=tax receipts; B = borrowing, θ = high powered money insertion)
(2)
Autarky: I = Snational
(3)
Snational = Sfederal + Sprivate
(4)
Sfederal = Budget Balance3 = T + θ - G
(5)
1
This primer is intended to present an abbreviated discussion of the included economic concepts and is not
intended to be a full or complete representation of them or the underlying economic foundations from which they
are built.
2
This primer was developed by Rick Haskell ([email protected]), Ph.D. Student, Department of Economics,
College of Social and Behavioral Sciences, The University of Utah, Salt Lake City, Utah (2013)
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When the Budget Balance is negative (-) there is a budget deficit (Sfederal is actually dis-savings), when it is positive
(+) there is a budget surplus (Sfederal is actually savings), and when it is zero (0) the budget is balanced. When θ = 0,
Sfederal is –B, -1 x B, or the opposite of borrowing (B).
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In trade: I = Snational + NCI
(6)
In autarky Investment = Savings; with trade Investment = Savings + Net Capital Inflows (NCI)
NCI = IM - X
(7)
Rearrange (1) to isolate I (investment)
I = GDP – C – G + IM - X
(8)
Substitute (6) into (7)
I = GDP – C – G + NCI
(9)
From (6) and (9) we see that
GDP – C - G = Snational
(10)
Which makes sense: a nation’s savings is equal to its GDP (income) minus C (consumption) minus its G
(Government spending)
All of this is to simply give us a more clear view of loanable funds, which is relevant when it comes to
monetary policy and it may be viewed as the connection between fiscal and monetary policy. Each of
the elements examined above is an element of fiscal policy except θ (high powered money), which is a
strictly monetary variable and in the US is the purview of the Federal Reserve. We’ve argued that fiscal
policy is exercised by the Executive and Legislative Branches of the Federal Government while monetary
policy is exercised by the nation’s Central Bank (Federal Reserve). But we know that borrowing (B) can
be effected through the US Treasury (Executive Branch) through the issuance of federal bonds (debt)
and the Federal Reserve as they purchase these bonds – so borrowing can be both a fiscal and monetary
tool. But high powered money (θ) is exclusively monetary and can only be manipulated by the Federal
Reserve. Both θ and B have direct impact on the loanable funds market.
The Loanable Funds Market
Think about the loanable funds market: the supply of funds available to be loaned to consumers, firms
and government as compared to the demand for funds to be loaned.
interest
rate (r)
Supply
r*
Demand
Q*
Quantity
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Consumers borrow money to meet demands arising from a belief that purchases toady will yield greater
utility in the future, enough greater to justify the cost of borrowing. Firms borrow based on a belief that
investments in materials, inventory or capital today will yield profits in the future greater than the cost
of borrowing. Governments borrow based on a belief that investments in infrastructure, defense,
transfer payments, etc. today will yield greater social welfare tomorrow than the cost of borrowing.
We can easily envision that fiscal policy as directed by the US Congress has a direct impact on both
demand and supply in this market. But we can also see that the Federal Reserve has direct impact as it
sets interest rate targets and is capable of expanding and contracting the supply of money in a
marketplace, which marketplace is no longer simply the US, but includes the entire world.
If firms expect increased opportunities for future profits, then they’re likely to expand their borrowing
to take advantage of these opportunities such that it increases the demand for loanable funds: shifts the
demand curve to the right and yields an increase in both r and Q. A government’s decrease in its budget
deficit (borrows less money to fund expenditures) results in a decreased demand for loanable funds:
shifts the demand curve to the left and yields a decrease in both r and Q. As such, we see that changes
in the demand for loanable funds are positively correlated with changes in r and Q.
If households increase their consumption such that household savings declines (remember that
household supply labor and financial capital to the markets) then we see the supply of loanable funds
shift to the left, resulting in an increase in r and decrease in Q. When a central bank (Federal Reserve)
increases the money supply through the purchase of bonds we see an increase in the supply of loanable
funds such that the supply curve shifts to the right, yielding an increase in Q and decrease in r. As such
we see that changes in the supply for loanable funds are positively correlated with changes in Q (as
supply increases Q increase) and negatively correlated in changes in r (as supply increases, r decreases).
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